After a deep recession, the U.K. economy started growing again in late 2009.

In its annual health check of the economy, the IMF says it is expecting growth of 1¾ percent in 2010, followed by 2 percent in 2011.

“There’s considerable uncertainty around this forecast, which makes it very important for policymakers to be vigilant and flexible,” IMF mission chief Ajai Chopra said. “Encouragingly, unemployment has stabilized, but it’s still too high. This crisis won’t be over until we start seeing significant falls in unemployment, and that’s going to make it very important to lay the foundations for sustainable, strong, and equitable growth.”

Very low real interest rates, the fall in sterling, and the global recovery could provide a bigger boost to growth. But further rapid debt reduction by households and companies, a sharp new downturn in the housing market, or greater than expected weakness in the euro area are all factors that could undermine the recovery now underway, according to the report.

"This crisis won’t be over until we start seeing significant falls in unemployment."

Every year, the IMF conducts reviews of its member countries’ economies. The analysis is subsequently discussed by the IMF’s 24-member Executive Board.

Rebuilding confidence

The U.K. fiscal deficit was 11 percent in 2009, a post-war record and one of the highest deficits in the world. As a result, debt is rising rapidly. After assuming office in May 2010, the Conservative-Liberal Democrat government has moved swiftly to announce a number of important policy initiatives to promote confidence and sustainable growth.

The cornerstone of the government’s policies is an ambitious plan to achieve a balanced cyclically-adjusted current budget by 2014/15 through a combination of spending cuts to reduce total government expenditure by more than 7 percentage points of GDP over the next six years and tax increases that include a bank levy and higher value-added and capital gains taxes. Many of these measures will be implemented during the government’s first year in office.

“The government has announced tough measures to ensure fiscal sustainability and also reduce the risk of a possible costly loss of confidence in public finances. Inevitably, the consolidation will slow short-term growth, but this is outweighed by the longer-term benefits,” Chopra said.

“Although consolidation is necessary, it’s important that it be fair, which means that it will be important to protect the poor and the vulnerable,” he added.

Restoring growth and jobs

Looking beyond the immediate future, there are many uncertainties surrounding the growth potential of the U.K. economy. The financial crisis not only depressed demand, it also put a dent in potential supply, which determines the economy’s ability to generate growth and new jobs, the report said.

Loss of skills in the labor force due to longer-term unemployment is one factor that could impact future growth. Unemployment rose from 5½ percent to 8 percent as a result of the crisis. Even though it has recently started to decline, it has already affected the many workers who lost their jobs during the crisis. The lack of new jobs also affect those seeking to enter the labor force for the first time.

Further job losses are expected in the public sector as the government starts implementing its planned budget cuts, so new jobs will have to be created mainly in the private sector.

Flexibility is key

Given all the uncertainties surrounding the outlook, the government should be ready to adjust its policies if conditions change. A key safeguard are the automatic fiscal stabilizers, which should be allowed to operate freely in both directions, the report said. In the unexpected but possible event that the economy experiences a significant downturn, temporary and targeted tax cuts should be considered, provided overall credibility of fiscal policy is maintained.

“If there’s a sharp and prolonged downturn in the economy, the pace of fiscal consolidation may need to be adapted,” Chopra said.

Monetary policy should also remain flexible. Asset purchases should resume if the recovery weakens. Conversely, if inflationary pressures continue to surprise on the upside, policy rates should be gradually tightened, according to the report.

"If there’s a sharp and prolonged downturn in the economy, the pace of fiscal consolidation may need to be adapted."

“The current accommodative stance of monetary policy remains appropriate. It will help offset the shrinkage in the budget,” Chopra said.

“Yes, inflation is running well above the 2 percent target, but this is due to a series of one-off price level shocks, such as the increase in the VAT, which will keep inflation above target in 2011 as well. But we do expect inflation to fall below target in 2012.”

Moving to a safer financial system

The financial sector is another key building block for the economic recovery. The bank stress tests carried out by the European Union in July 2010 confirmed the relatively good health of British banks. The tests facilitated banks’ efforts to tap markets for longer-term funding. But many banks still need to roll over or replace large amounts of wholesale funding coming due over the next few years, underlining the importance of ongoing efforts to strengthen the financial system.

“The health of the U.K. banking system has improved, but it’s going to be important to continue progress in this area to be able to support the recovery and cope with possible future shocks. This means that supervisors will need to maintain pressure on banks to rebuild capital over time and to also strengthen their funding models,” Chopra said.

Private credit remains relatively weak. U.K. consumers responded to the global financial crisis by saving more of their income and paying off debt. The gross household savings rate jumped by more than 6 percentage points, to a peak of 7¾ percent in mid-2009. Consumers have recently started to spend more of their disposable income, but lending to households remains weak. Corporate credit is also weak, reflecting a lower appetite for investing.

Looking ahead

In sum, the U.K. economy is on the mend. Economic recovery is underway, unemployment has stabilized, and the health of the financial sector has improved. But the government should be ready to adjust its policies, should growth drop back or speed up beyond what is currently expected.

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